ChapterMcGraw-Hill/IrwinCopyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.Mutual Funds4-2Mutual Funds: Overview• Our goal in this chapter is to understand the different types of mutual funds, their risks, and their returns.• Around 1980, 5 million Americans owned mutual funds.• However, by 2005, 92 million Americans in 54 million households owned mutual funds.• In 2004 investors added $288 billion in net new funds to mutual funds.• In 2004, mutual fund assets totaled $8 trillion.4-3Mutual Funds: Overview, Cont.• Mutual funds are simply a means of combining or pooling the funds of a large group of investors.• The buy and sell decisions for the resulting pool are then made by a fund manager, who is compensated for the service provided.• Like commercial banks and life insurance companies, mutual fundsare a form of financial intermediary.4-4Investment Companies and Fund Types, I.•AnInvestment company is business that specializes in pooling funds from individual investors and making investments.•AnOpen-end fund is an investment company that stands ready to buy and sell shares in itself to investors, at any time.•A Closed-end fund is an investment company with a fixed number of shares that are bought and sold by investors, only in the open market.4-5Investment Companies and Fund Types, II.4-6Investment Companies and Fund Types, III.• Net asset value (NAV) is the value of the assets held by a mutual fund, divided by the number of shares. • Shares in an open-end fund are worth their NAV, because the fund stands ready to redeem their shares at any time.• In contrast, share value of closed-end funds may differ from their NAV.4-7Mutual Fund OperationsOrganization and Creation• A mutual fund is simply a corporation. It is owned by shareholders, who elect a board of directors.• Most mutual funds are created by investment advisory firms (say Fidelity Investments), or brokerage firms with investment advisory operations (say Merrill Lynch).• Investment advisory firms earn fees for managing mutual funds.4-8Mutual Fund OperationsTaxation of Investment Companies• A “regulated investment company” does not have to pay taxes on its investment income.• To qualify, an investment company must:– Hold almost all its assets as investments in stocks, bonds, and other securities,– Use no more than 5% of its assets when acquiring a particular security, and– Pass through all realized investment income to fund shareholders4-9Mutual Fund OperationsThe Fund Prospectus and Annual Report• Mutual funds are required by law to supply a prospectus to any investor who wishes to purchase shares.• Mutual funds must also provide an annual report to their shareholders.4-10Mutual Fund Costs and FeesTypes of Expenses and Fees• Sales charges or “loads”– Front-end loads are charges levied on purchases.– Back-end loads are charges levied on redemptions.• 12b-1 fees. SEC Rule 12b-1 allows funds to spend up to 1% of fund assets annually to cover distribution and marketing costs.• Management fees: – Usually range from 0.25% to 1.00% of the funds total assets each year. – Are usually based on fund size and/or performance. • Trading costs– Not reported directly– Funds must report "turnover," which is related to the amount of trading.– The higher the turnover, the more trading has occurred in the fund.– The more trading, the higher the trading costs.4-11Mutual Fund Costs and FeesExpense Reporting• Mutual funds are required to report expenses in a fairly standardized way in their prospectus.– Shareholder transaction expenses - loads and deferred sales charges.– Fund operating expenses - management and 12b-1 fees, legal, accounting, and reporting costs, director fees.– Hypothetical example showing the total expenses paid by investors through time per $10,000 invested.4-12Example: Fee Table4-13Mutual Fund Costs and FeesWhy Pay Loads and Fees?• After all, many good no-load funds exist.• But, you may want a fund run by a particular manager. All such funds are load funds.• Or, you may want a specialized type of fund.– Perhaps one that specialized in Italian companies– Loads and fees for specialized funds tend to be higher, because there is little competition among them.4-14Short-Term Funds, I.• Short-term funds are collectively known as money market mutual funds.• Money market mutual funds (MMMFs) are mutual funds specializing in money market instruments.– MMMFs maintain a $1.00 net asset value to make them resemble bank accounts.– Depending on the type of securities purchased, MMMFs can be either taxable or tax-exempt.4-15Short-Term Funds, II.• Most banks offer what are called “money market” deposit accounts, or MMDAs, which are much like MMMFs.• The distinction is that a bank money market account is a bank deposit and offers FDIC protection.4-16Long-Term Funds• There are many different types of long-term funds, i.e., funds that invest in long-term securities.• Historically, mutual funds were classified as stock funds, bond funds, or income funds.• Today, the investment objective of the fund is the major determinant of the fund type.4-17Stock Funds, I.• Some stock funds trade off capital appreciation and dividend income.– Capital appreciation–Growth– Growth and Income– Equity income• Some stock funds focus on companies in a particular size range.– Small company–Mid-cap• Some stock fund invest internationally.– Global– International– Region– Country– Emerging markets4-18Stock Funds, II.• Sector funds specialize in specific sectors of the economy, such as:– Biotechnology– Internet– Energy• Other fund types include:– Index funds– Social conscience, or “green,” funds– “Sin” funds (i.e., tobacco, liquor, gaming)– Tax-managed funds4-19Bond Funds• Bond funds may be distinguished by their– Maturity range– Credit quality– Taxability– Bond type– Issuing country• Bond fund types include: – Short-term and intermediate-term funds– General funds– High-yield funds– Mortgage funds – World funds– Insured funds– Single-state municipal funds4-20Stock and Bond Funds• Funds that do not invest exclusively in either stocks or bonds are often called “blended” or “hybrid” funds.• Examples include:– Balanced funds– Asset allocation funds– Convertible funds– Income funds4-21Mutual Fund Objectives: Recent Developments, I.•